How To Build A Portfolio

Our beginners' series looks at which shares to build up your portfolio with.

We've covered quite a lot of ground in our series on investing for beginners, and we now know the mechanics of actually getting going. Time to get on to the hard question, then, which can stump even the most hardened of investors: 'What shall we buy?'

What is the best number of different shares to own? How much should I diversify? Should I go for capital appreciation or income? How about growth versus value?

What strategy?

Some individuals, especially those interested in specific industries, have very focused portfolios -- there are, for example, people who invest solely in the oil and gas exploration business.

Some specialise in what is often known as deep value, which really means looking at shares whose prices are unusually cheap relative to basic fundamentals. A company might, say, possess assets (cash, goods, equipment, etc) whose value exceeds the value of its shares. That's tricky to assess, mind, because of the vagaries of accounting for asset values, and it's easy to get wrong.

Others will plump for growth shares, and look for small companies who they believe have a good chance of making it big. That can be rewarding too, but it's also risky. While some make it big, many fall by the wayside. And sometimes a company will start off well and its shares will fly, and then you buy in just before something goes wrong and they come crashing back down again.

A balanced portfolio

These are strategies you might want to investigate when you have a bit of experience, but most beginners will go for a simple diversified portfolio.

For example, just looking at the FTSE 100 index, you might choose, say, BT Group (LSE: BT-A) to get yourself into the telecommunications business.

You could then go for a consumables manufacture like Unilever (LSE: ULVR), which owns so many popular brands it's hard not to be a customer.

Then thinking about the world's energy needs, there are the two oil and gas giants BP (LSE: BP) and Royal Dutch Shell (LSE: RDSB) to choose from.

Add, say, a multi-utility like United Utilities (LSE: UU), an insurer like Prudential (LSE: PRU) and perhaps a big pharmaceuticals company like GlaxoSmithKline (LSE: GSK), and you already have the makings of a nicely balanced portfolio without having looked outside the FTSE 100.

Good smaller ones, too

There are plenty of solid companies paying decent dividends in the next layer down too, the FTSE 250, and you can look to expand your portfolio there. And then why not add a bit of excitement by going for a FTSE Small Cap company or two?

The key to Foolish investment is to pick companies that you'd want to hold for a lifetime, ideally ones paying decent dividends, and minimise the costs by resisting the temptation to buy and sell frequently.

In all, if you can pick five to 10 good companies, spread across sectors, with a mix of large and medium sized ones, and hold onto them for several decades, the chances are you'll get a nice mix of capital appreciation and dividend income over the years.

As Peter Lynch has said - out of 5 shares you buy, 1 will be a disaster, 3 will be so-so and 1 (if you are lucky) will be a star. So I would suggest a portfolio of 10-15 companies (rather than 5-10 described above), diversified by sector.

Warren Buffett's sound advice is 1) Buy shares in companies you understand 3) Look for a sustainable competitive advantage 3) Look for sensible management and 4) Don't pay too much. He also says not to buy more companies than you can keep track of!

Picking 4 or 5 different stocks isn't really the definition of diversification, especially as major market equities are all highly correlated. Some useful advice would be to tell readers to diversify into different asset classes based on their correlation and weight your portfolio on a risk-parity basis.

different asset classes based on their correlation and weight your portfolio on a risk-parity basis.

As a relative rookie investor I find terms like "risk-parity" and "correlation" to be fairly meaningless. I think the articles as they stand, for new investors to dip a toe are good value, given the limitations of the short blog-length pieces.

Perhaps Hedgie could elaborate here or on the forum boards how someone new to investing should understand risk-parity. Perhaps he/she could provide the risk-parity of the shares mentioned in the article by way of example - or their correlation. Of say BT or Unilever. That might be useful to someone who's never invested in a company before.

"Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas (together with different asset classes based on their correlation.) Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'?"

My hunch is that Uncle Warren's got it about right, though many Fools think they know better.And of course they could be right.

goodlifer - you just comfort yourself in the assumption that uncle Warren does nothing more than buy a few "cheap" value stocks and hold them as long as possible. If you think that's all he does then good luck to you....really!

I am not talking about EMH, dynamic hedging or beta. I am talking about diversification and the true meaning of the word. Markowitz's modern portfolio theory is some of the greatest work of the 20th Century as far as finance is concerned and if you doubt that diversification is an effective method then you are basically questioning mathematics.

I am the first to agree that many in the industry over-complicate matters and use a multitude of terms to baffle the investing public but at the same time, there are some very valid tools that you should ignore at your peril.

There is no free lunch in investing but proper diversification is about as close as you can get....so long as it is properly implemented (something VERY few have done).

FYI as well..."Risk parity" just means that you weight your portfolio according to risk. That is to say, a portfolio that is 60% stocks and 40% bonds is more like 80/20 if you look at it from a risk perspective (i.e. 80% of your risk is in equities, not 60%!). It's a fancy term but it's not rocket science.

Happy to elaborate on the boards if you let me know where JohnnyCyclops.

Horses for courses! I hold (usually) about 30 companies. That in itself is diversification and allows flexibility re sector class. I also hold some funds for long term, but watch them closely. Funds and shares and liquidity via premium bonds are my asset classesI split my stock portfolio into 3 parts:±15% growth with >2% divi re-invested on a hold tag and after rigorous DYOR: ±20% my latest "fun" strategy of FT100/250 highish divis buys before ex-d and selling after record date if the SP holds reasonably after the obvious ex-d or pay date fall, again only if giving me a profit. (I use a £5.95 broker for this and below).±65% defensive of 5% divi with a strict mandate of sell after 15-20% profit after all buy-in/sell out costs. This covers general market volatility and I can always buy back in.I am ahead of inflation (the higher statistic) for the third year by a few %, so I am a happy camper.Disclaimer: I am retired and have 10 hours per day to DMOR (loving every minute), continue to learn, and can afford to lose 50% without a sleepless night. This is easily achieved by re-investing my profits into crates of wine.Before my liver explodes I would like to thank the MFool resources / authors and the frequent posters / boards from whom I have (and will continue) to learn a lot.

@Goodlifer - I don't know, that's precisely the point. Equities have a positive long term EXPECTED (the operative word) return but I would say all 3 events are possible. Invest in the S&P in mid 2000 for example and you're only just above water.

Let me explain it this way and I'll try not to bore you and please don't just write off some of the terms I use as jargon as they do make sense...I promise.

What do all investors ultimately want? Answer: essentially I believe all investors want as much return as they can possibly get for every increment of risk they incur. Risk and return are intrinsically linked, so for a 10% long term return, you will have to assume a risk of at least 10% to achieve it. Sharpe ratio (although it has its limitations for penalising upside or "good" volatility) is one measure of this. Sharpe ratio defines "how well the return of an asset compensates the investor for the risk taken".

Most people therefore want as high a Sharpe ratio as possible agreed? Right, so a long term Sharpe ratio of 1 is both outstanding and also very rare. A better measure in my opinion is the MAR ratio (average annual return divided by the worst peak to valley drawdown)....ie how much gain do you get for how much pain. Equities have a long term average annual return of around maybe 5-6% with a worst peak to valley drawdown of over 50% so if you just invest in equities (and I will come to diversification in a minute), there is a big disparity between the returns you achieve for the risk you're taking on. Does that mean they are a poor investment? No but it does mean you have to combine them with other things to achieve your overall high sharpe ratio or nice stable upward equity curve. And I don't mean other equities either because major market equities are all highly correlated and if the market crashes, by and large they will all go down.

The mistake I believe 99% of investors make, particularly when selecting investment funds, is to think "if I take investment A with a high Sharpe ratio and combine with with investment B, also with a high Sharpe ratio...the result will be the best possible Sharpe ratio or the nicest, most stable upward equity curve". Wrong wrong wrong! The problem with individual high Sharpe ratio assets (this could be a single stock, fund whatever you like) is that on their own, a high Sharpe ratio is not only rare but invariable has a limited shelf life. You are far better to combine assets that have:

A) A positive long term expected returnB) A time series correlation as close to +1 as possible and return series correlation close to -1 as possible

A is obvious but all B means in very basic terms is that if you have two investments that fit the criteria for argument's sake (the exact criteria being impossible to achieve)....is that when instrument A goes up, instrument B will go down not only by the same amount but at the exact same time. This is the key to achieving the highest possible combined Sharpe ratio and you will find that the very best people in the industry who have the best performance records do not select lots of high Sharpe strategies but instead lots of lower Sharpe strategies that are negatively correlated to each other.

How do you put this into practise as a novice investor then? Well first of all, don't JUST invest in equities because on their own, they are not a good investment. You can argue about stock picking and Buffett and all the rest of it but the fact remains that 95% of people / fund managers under-perform the market so if you are someone who likes probabilities then you are far better getting your equity exposure at low cost in the form of an index tracker....even Warren himself says this on youtube. Then you have to find asset classes that have both a long term expected return AND a low (good) to negative (better) correlation to everything else you are investing in. Think commodities, bonds, currencies, managed futures (many are negatively correlated to equities) and then base your portfolio on how much risk you are taking in each sector. I don't have enough space to write about how you do this but google "risk parity" and somewhere there will be a paper explaining what I mean.

"All investors want as much return as they can possibly get for every increment of risk they incur."Not true. For all I know some, many, or even most investors may want this, but not all.Not me anyway.I just want to protect my lolly from inflation and get a reasonably fair rate of return.

"If the market crashes, by and large they (all brands of equities) will all go down." True, But, why does that matter to a dividend investor like me?I like the lowest possible Footsie - it means plentyof juicy bargains to reinvest my dividend payments in.It's true I may make a paper loss on some of, or even all, my holdings, but what does that matter unless I want to sell them?And why should I want to do that?

"The mistake I believe 99% of investors make,,,is to think "If I take investment A with a high Sharpe ratio and combine with with investment B, also with a high Sharpe ratio...the result will be the best possible Sharpe ratio or the nicest, most stable upward equity curve"I belong to the 1%,whose tiny minds have never been troubled by such morbid thoughts.

"If you are someone who likes probabilities then you are far better getting your equity exposure at low cost in the form of an index tracker....even Warren himself says this on youtube." Uncle Warren is on record as saying that tracker funds are probably the best solutiom for most nvestore,Once again we need to distinguish between "most" amd "all." He himself is living proof that he can't mean more than "most."

Anyway, my approach has worked OK so far, thoogh of course You never know what you may meet,Round the next corner and in thr next street.

And there's no obvious reaso why yours shouldn't work just as well, or even better, however dodgy I may think the premises are on which it seems to be based.

As far as I can see my applecart is unlikely to be upset unless the whole economy goes into meltdown.In that case we'll all be in the caccy.

The best bet would bes to fill the garden up with potatoes, leeks, beans, peas, garlic, rhubarb etc.Perhaps, like me, you do that anyway already!.

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